Impact of Investment Banks on the U.S Economy

Introduction

Investment banks have been instrumental in the growth of the US economy. Historically, investment banks have enabled businesses to raise raising capital, in addition to facilitating the sale and financing of bonds and securities. Investment banks have also been instrumental in corporate mergers and acquisitions (the United States General Accounting Office 10). Today, investment banks still facilitate such financial activities as trading commodities and derivatives. In addition, they also offer investment and broker-dealer advisory services (PSI Report 39). Lately, most investment banks have taken an active role in the mortgage market by working hand-in-hand with mortgage brokers or lenders in the sale of mortgage-backed securities and loans. They have also acted as underwriters to securities sold by businesses to the public and as underwriters in the sale of CDO securities to investors through private placements (PSI Report 40).

The behavior of Investment banks in respect to their size

Several years before the start of the global financial crisis, the number of local and regional banks was controlled by state and federal laws. In case a bank encountered losses, the United States would not hesitate to close such a bank. This move was necessary so as to protect depositors from incurring losses on their investments. In addition, the move helped to avoid possible damage to the U.S economy or banking system (PSI Report 22). In other words, the U.S government was trying to decentralize the banking system. This activity not only helped to promote competition, but also diffused credit available in the marketplace. In addition, the decentralization process was also aimed at avoiding unwarranted concentration of financial power.

In the mid-1990s, the banking industry in the United States witnessed substantial changes whereby rules governing operations of banks were relaxed. Some of the new rules enforced rules while others encouraged banks to increase their risk-taking activities (PSI Report 22). The 1993 Glass-Steagall Act was also repealed by Congress in 1999. This rule had required investment banks, securities firms, and banks to operate separately. With the repeal of this Act, these financial institutions could now merge their operations.

In addition, Congress eliminated a section of the Glass-Steagall Act that prohibited banks from participating in proprietary trading. Eliminating this prohibition also excused investment banks from being regulated by the Federal government directly. The above steps paved way for the formation of large financial conglomerates. Financial institutions became bigger and more complex. Within a period of slightly over a decade, the U.S economy had already created too big-to-fail financial institutions.

Lack of accurate data on houses prices

In the months preceding the global financial crisis, investment banks were faced with a lack of data on the falling or stagnating home prices. Data used by investment banks in their subprime mortgage models did not capture the falling and/or stagnating housing prices. Models used by investment banks in calculating bond subordination and subprime mortgage lending criteria relied heavily on performance experience that had largely been accumulated for more than a decade. Most of this information was mainly accumulated in the mid-1990s (PSI Report 15), a time when the housing market in the United States was booming. In other words, investment banks made their investment decisions based on data that was not reflective of the actual market conditions.

Although relying on historical data dating back to the Great Depression was a wise move by investment banks in that past trends could be replicated in the future, on the other hand, some of the data used by investment banks to support their decisions were no longer reliable in the current market conditions (PSI Report 16). Lack of appropriate data for use in RMBS modeling meant that credit rating agencies could not precisely predict loss rates and mortgage default when housing prices stagnated. This also had a negative effect on CDOs (collateralized debt obligations) and RMBS (residential mortgage-backed securities) ratings.

Reaction of the financial system regulators to the 2008 financial crisis in the U.S

Before the financial crisis, investors would normally buy long-term CDOs and RMBSs securities in the hope that they would provide them with a steady income. However, in 2006, the high-risk mortgages essential to the above securities were losing their value very quickly, prompting worried investors to sell their CDOs and RMBS securities. This was not an easy thing to do considering that there was no active market at the time (Rude 2). Nonetheless, some investment banks still managed to buy a number of high-risk RMBS securities. Other investors began insuring their CDOs and RMBS securities against potential losses by purchasing a credit default swap (CDS). The CDS would pay off in case the RMBS and CDO securities encountered either loss, in addition to additional negative credit events.

Two years before the start of the global financial crisis, most investment banks had already standardized CDS contracts. These would prove quite useful in enabling them to buy both CDO and RMBS securities. A number of investors started buying CDS contracts in the hope that they would benefit from certain CDO and RMBS securities they envisaged would lose value. As such, they were more concerned with making a profit, as opposed to hedging against possible losses from CDO and RMBS securities (PSI Report 39). Investors could also ‘short’ the mortgage market by utilizing synthetic CDOs. This particular approach involves the establishment of a synthetic CDO by an investment bank. Such a synthetic CDO so created can then be used to reference various RMBS securities.

In order to take the “short” position, an investor can buy premiums to the CDO and get a promise that he/she would receive a certain amount of money in case the referenced assets attracted such a negative credit event as a credit rating downgrade or default. In case such an event occurred, the short investors would need up receiving an agreed-upon amount from the CDO to cover the loss. Because such a move actually entailed removing earnings of the COD, long investors end up losing (PSI Report 40). As such, investors made use of synthetic CODs to RMBS securities that were projected to earn losses.

Investment banks were also involved in proprietary trading, in which they purchased and retained CDO and RMBS securities in their investment portfolios. Other investment banks decided to retain such securities in their trading accounts (PSI Report 23). They would then find use as inventory hedging, short-term trading activity, offering collateral in the case of short-term loans, and in-market making for clients. The U.S taxpayers had to bail out some of the investment banks that had been declared bankrupt following their reckless risk-taking activities in a bid to protect the U.S economy.

Lawsuits against investment banks

A number of investment banks are already facing lawsuits for the role they played in the global financial crisis. For example, JP Morgan is faced with a $ 20 billion lawsuit that is being spearheaded by New York’s Attorney General. The lawsuit accuses JP Morgan, through Bear Sterans, an investment bank that was purchased by the former in 2008, of taking part in huge frauds in residential mortgage-backed securities (BBC News para. 2). Other investment banks that have also been sued include Goldman Sachs, which is being accused of deceiving investors with their subprime mortgage products even as the banks were aware that the housing market was showing signs of collapse.

Conclusion and recommendations

Investment banks have been instrumental in facilitating the growth of the US economy. Investment banks enable businesses to raise capital, help to finance bonds and stocks, and are also involved in the sale of mortgage-backed securities and mortgage loans. The decision by the US government to decentralize the banking system by abolishing the Glass-Steagall Act that prohibited investment banks from proprietary trading saw most banks grow in complexity and size. Prior to the financial crisis, long-term CDO and RMBs securities were quickly losing value. Most investment banks bought these high-risk RMBs and CDO securities, in addition to their involvement in proprietary trading. The short-term activities saw long-term investors lose money and some of the investment banks had to be bailed out by the government after being declared bankrupt. To avoid a repeat of the same mistakes in the future, federal regulators should augment existing regulatory prohibitions on investment banks against abusive practices that could endanger the investments of individuals and businesses. Also, the ban on proprietary trading should be enforced once more to reign in on investment banks that are likely to abuse privileges granted to them.

Works Cited

BBC News. JP Morgan sued over Bear Stearns mortgage securities. 2012. Web.

PSI Report 2011. Wall Street and the Financial Crisis: Anatomy of a Financial Collapse. PDF file. Web.

Rude, Christopher 2009, The World Economic Crisis and the Federal Reserve’s Response to It: August 2007-December 2008. PDF file. Web.

United States General Accounting Office 2003, Investment Banks the Role of Firms and their Analysts with Enron and Global Crossing. Web.